On April 13, 2016, the U.S. Department of the Treasury issued proposed regulations under Section 305(c) of the Internal Revenue Code that would resolve certain issues relating to the amount and timing of deemed distributions resulting from conversion rate adjustments with respect to rights to acquire corporate stock. The proposed regulations do not alter the fact that, under certain circumstances, a distribution with respect to such stock rights may be deemed to occur—which the preamble describes as clear under current law. Instead, the proposed regulations are focused primarily on the methodology for determining the amount of a deemed distribution, the time when income arises, and when reporting and withholding obligations attach with respect to a deemed distribution. The proposed regulations would affect corporations issuing such stock rights, their shareholders and holders of such stock rights, and withholding agents with respect to deemed distributions under such stock rights.

Background of Proposed Section 305(c) Regulations

Pursuant to Section 305 and the current regulations thereunder, certain actual or deemed distributions of stock or stock rights are treated as distributions to which Section 301 applies, meaning that they are taxable as dividends to the extent of the issuer's current or accumulated earnings and profits. For example, if a distribution or a series of distributions by a corporation has the effect of the receipt of property by some shareholders and an increase in the proportionate interest of other shareholders in the assets or earnings and profits of the corporation, then all of the distributions are subject to Section 301.

For purposes of Section 305, the term "stock" includes rights to acquire stock, and the term "shareholder" includes the holders of rights to acquire stock. A corporation may issue such stock rights in many forms, including convertible debt or stock, warrants, options, subscription rights, and similar instruments. These stock rights typically include certain adjustments having the effect of providing the holders with the economic benefit of actual distributions of stock, cash, or other property to the issuer's shareholders, and conversely, of preventing the dilution of the shareholders' interests. The Treasury Department is authorized under Section 305(c) to promulgate regulations to treat changes in the conversion ratio of convertible instruments, and other similar adjustments, as distributions to the holders whose proportionate interests are increased. The Treasury Department and the IRS have taken the position for over 40 years that an increase in the conversion ratio of a convertible debt instrument may be treated as a deemed distribution to the holder to which Section 301 applies. Further, under current regulations, an adjustment to a right to acquire stock in order to compensate the holder for a distribution of cash or property to shareholders that is taxable under Section 301 generally would be treated as a deemed distribution to which Sections 305 and 301 apply.

Amount of Deemed Distribution

The current regulations are unclear as to the amount of a deemed distribution to a holder of stock rights resulting from an adjustment: The distribution may be a distribution of stock rights, the amount of which is the fair market value of the rights, or a distribution of the stock to which the rights relate, the amount of which is the fair market value of the stock. For deemed distributions occurring before the final regulations are published, the IRS will not challenge either position.

Under the proposed regulations, a deemed distribution with respect to stock rights, such as an increase in the conversion rate to compensate the holders for a distribution of cash or property to shareholders, is characterized as a distribution of additional stock rights to the holders of such rights, the amount of which is the excess of the fair market value of the rights immediately after the adjustment over the fair market value of the rights without the adjustment. In determining the fair market value of a stock right, any particular facts pertaining to the holder's rights, including the number of shares or rights held by such holder, would be disregarded. When the terms of a convertible debt instrument or other stock right provide that a payment of cash or other property to the holder causes a reduction in the conversion rate, this increases the proportionate interests of the shareholders in the issuer's assets or earnings and profits, resulting in a deemed distribution of stock to the shareholders. The amount of this deemed distribution would be the fair market value of the stock deemed distributed.

Timing of Deemed Distribution

The deemed distribution is treated under the proposed regulations as occurring at the time the applicable adjustment occurs in accordance with the terms of the instrument, but in no event later than the date of the distribution of cash or property resulting in the deemed distribution. For example, in the absence of specific provisions in the instrument setting forth an earlier time, the deemed distribution for an adjustment relating to a right to acquire publicly traded stock would occur immediately prior to the opening of business on the ex-dividend date for the distribution of cash or property that results in the deemed distribution, and the deemed distribution for an adjustment relating to a right to acquire non-publicly traded stock would occur on the date that a holder is legally entitled to the distribution of cash or property that results in the deemed distribution.

Withholding on Deemed Distributions

The proposed regulations would clarify that a withholding agent has an obligation to withhold on a deemed distribution on a security made to any nonresident alien, foreign partnership, or foreign corporation at a 30 percent rate (unless a reduced rate of withholding applies), and that the issuer of such a security is a withholding agent. The proposed regulations would add an exception for withholding agents other than the issuer, under which there would be no obligation to withhold unless, by the due date for filing Form 1042 (Annual Withholding Tax Return for U.S. Source Income of Foreign Persons), either the issuer meets its reporting requirements under Section 6045B (by furnishing an issuer statement or publicly reporting the information required under that section) or the withholding agent has actual knowledge that a deemed distribution has occurred, in which case the obligation to withhold would not arise until January 15 of the year following the calendar year of the deemed distribution.

Under the proposed regulations, a withholding agent generally would be required to withhold the taxes on the earliest of: (i) the date on which a future cash payment is made with respect to the security; (ii) the date on which the security is sold, exchanged, or otherwise disposed of (including a transfer of the security to another account not maintained by the withholding agent or a termination of the account relationship); or (iii) the due date (not including extensions) for filing Form 1042 with respect to the calendar year in which the deemed distribution occurred. If there are not sufficient future cash payments on the security, and the security has not been disposed of or transferred before such due date, then under the proposed regulations, the withholding agent can satisfy the withholding obligation by withholding on other cash payments made to the same beneficial owner or by liquidating other property held in custody for the beneficial owner or over which it has control, and may obtain the property from which to withhold through additional contributions obtained from the beneficial owner.

Issuer Reporting Under Section 6045B

Section 6045B requires the issuer of a specified security (for example, stock, a convertible debt instrument, or a warrant) to report on Form 8937 (Report of Organizational Actions Affecting Basis of Securities) certain information relating to any organizational action that affects the basis of the security to both the IRS and the holders of the security. A conversion rate adjustment that results in a deemed distribution under Section 305(c) generally is an organizational action that will affect a holder's basis in a specified security. An information return must be filed with the IRS by the earlier of 45 days after the organizational action or January 15 of the calendar year following the organizational action. In addition, the issuer must send a written statement (which can be a copy of the issuer return) to holders by January 15 of the calendar year following the organizational action. The issuer can satisfy both of these requirements by posting the required information on its public website by the due date for reporting the issuer return to the IRS. These reporting requirements apply to convertible debt instruments for organizational actions occurring after December 31, 2015.

Under current regulations, however, an issuer is not required to send a statement to exempt recipients, such as C corporations and foreign persons, nor is an issuer required to file an issuer return if the issuer reasonably determines that all of the holders of the security are exempt recipients. The proposed regulations would eliminate the exempt recipient exception to reporting under Section 6045B for deemed distributions under Section 305(c).

Proposed Effective/Applicability Dates

The proposed regulations generally would apply to deemed distributions occurring on or after the date the regulations are published as final. Taxpayers are permitted, however, to rely on the regulations under Section 305 prior to that date, and withholding agents are permitted to rely on the proposed withholding rules for deemed distributions on or after January 1, 2016. For purposes of determining the amount of a deemed distribution occurring prior to the date of publication, a taxpayer may determine the amount of the deemed distribution by treating such distribution either as a distribution of a right to acquire stock or as a distribution of the actual stock to which the right relates.